The US economy is facing an 'impossible trinity' that will be a nightmare for investors

The US economy is facing a new "impossible trinity" that will
most likely create major headaches for investors in stocks and
bonds alike.

In a note out Tuesday, Rineesh Bansal, an analyst at Deutsche
Bank, wrote that the US economy was striving to achieve three
outcomes: higher wages, more inflation, and higher profits.

The problem is that it can pick only two.

In economics, the classic "impossible trinity" that policymakers
face is a two-out-of-three choice on maintaining a fixed exchange
rate, cross-border capital flows, and independent monetary
policy.

(In the US, for example, money can freely flow in and out of the
economy, its monetary policy is independent, and the value of the
US dollar is not fixed.)

The new trinity facing the US economy is that policymakers —
read: the Federal Reserve — want inflation to run closer to their
2% target and wages to increase, while investors attribute much
of the success of the postcrisis stock rally to high levels of
corporate profitability (and, as a result, higher earnings).

Wages, as Deutsche Bank outlines, are the sum of
labor productivity, prices, and labor's share of output.

Slightly more comprehensibly, this formula accounts for how much
output a business gets per hour worked by its employees, how much
the business gets paid for that output, and then how much of that
pay is transferred to employees.

Here's Deutsche Bank (emphasis mine):

The theory behind this new 'impossible trinity' is intuitively
simple. If workers' wages rise faster than their productivity,
the companies paying those higher wages face two choices. They
can either pass on the extra costs to customers, thereby leading
to higher overall prices and rising inflation, or they can absorb
the extra costs resulting in lower profit margins. Or in
economist speak, increases in nominal wages must equal the sum of
productivity improvements, price rises and changes to labour's
share of output (which is the flip-side of profit margins). [...]

For the entire second half of the last century, growth in
nominal wages tracked the sum of productivity growth and
inflation while leaving labour's share of output largely
unchanged. However, the first decade of this millennium saw
nominal wages failing to rise sufficiently to compensate workers
for rising prices and their productivity gains. The result was a
substantial decline in labour's share of output through the
decade of the 2000s.

And these two charts from Deutsche Bank tell the whole story.

First, we see how labor's share of output collapsed in the 2000s
...

Deutsche
Bank

... which leads to a major boom in corporate profitability seen
during the same period.

Deutsche
Bank

And so it's the tension between these forces that really gets at
the heart of why markets seem so stalled out.

Again, the Fed explicitly wants inflation to move higher and
wages to increase, and Deutsche Bank argues that Fed officials
continually citing less-than-stellar wages increases as evidence
of slack remaining in the labor market make this a de facto
official reason for keeping rates low.

Investors, meanwhile, want more profits and earnings. But the Fed
also wants investors to be happy;
the "third mandate" of the Fed is financial stability, which
has come to be taken as stocks not tanking and bond yields not
ripping higher, which would potentially be jeopardized by a
prolonged and sustained decrease in profits.

The problem is that this sort of looks as if it can go two ways,
and there are losers in multiple directions.

Deutsche Bank again (emphasis mine):

Consider two possible scenarios in this situation. Firstly, the
labour share of output, and therefore corporate profit margins,
remain constant at current levels. This implies inflation
has to rise to 3.5 per cent and would decimate many fixed income
investors given current inflation expectations for the next five
years are barely over one per cent currently. In some
ways, recent signs from the Federal Reserve that it is willing to
let the economy 'run hot' for a while, that is, tolerate
inflation above its two per cent target might signal this is the
central bank’s preferred outcome.

Conversely, if the Fed chooses to enforce its two per cent
inflation target religiously, the labour share of output would
grow at 1.5 per cent per annum. The historical
relationship with corporate profit margins would suggest that in
this scenario, profit margins would fall by nearly 1.3 percentage
point a year from their current levels of 10 per cent. Current
levels of the stock market do not suggest that equity investors
are prepared for profit margins halving in the next 3-4
years.

The current political cycle in the US has seen the decline of
middle-class working wages get significant play as something that
must be addressed. On both the right (Donald Trump) and left
(Bernie Sanders), presidential candidates have rallied around
this idea and seen success.

But any pickup in these wages would have to come from somewhere.
Namely, corporate profits.

And it is these profits that have buoyed financial markets, which
to an extent have allowed the economy to come as far as it has in
the seven years since the recession.

Something will have to give. Or perhaps nothing will.

Which, depending on how you see it, is either good or bad.
Remember, this is called an "impossible trinity" for a reason:
Someone loses.